Experimental Business Research II springer 2005 phần 7 pps

Penalty aversion:Bonus contract perceived as fairer Employee Effort Expected Disappointment Perceived Fairness Figure 1.. Specific-ally, RQ2 addresses whether expected disappointment, per

H1: Employees prefer bonus contracts to economically equivalent penaltycontracts.

Before we address expected differences in effort between bonus and penaltycontracts, we first hypothesize general effects in our second and third hypothesesthat we expect to hold for both bonus and penalty contracts Our second hypothesisaddresses the effect on effort of employees’ expected disappointment about having

to pay a penalty or not receiving a bonus We do not distinguish between bonuscontracts and penalty contracts because disappointment is expected to affect effortregardless of whether the contract is framed as a bonus or as a penalty Specifically,

we predict that employees who expect to feel more disappointed about the spect of receiving lower compensation (either by having to pay a penalty or by notreceiving a bonus) will expend more effort to avoid that outcome than employeeswho expect to feel less disappointed about receiving the lower final payment Thisprediction is consistent with conventional economic theory, which assumes thatemployees with greater incremental utilities for a higher monetary outcome (i.e.,receiving the higher final payment without having to pay a penalty or forgo a bonus)will expend more effort to ensure that they receive that outcome Thus, it followsthat employees with a greater incremental utility for receiving a higher monetaryoutcome will experience a greater reduction in utility from not receiving that out-come In our study, “expected disappointment” about not receiving the bonus orhaving to pay the penalty corresponds to this reduction in utility from not receivingthe higher final payment

pro-H2: Greater expected disappointment will result in higher employee effort

Our third hypothesis relates to the effect of perceived fairness on effort Manystudies in psychology (e.g., Goranson and Berkowitz 1966; Greenberg and Frisch1972; Greenberg 1978) and experimental economics (e.g., Kahneman, Knetsch andThaler 1986; Fehr, Kirchsteiger and Riedl 1993; Fehr, Gächter and Kirchsteiger1997; Fehr, Kirchler, Weichbold and Gächter 1998; Charness and Rabin 2002;Hannan, Kagel and Moser 2002) have shown that individuals who feel they aretreated fairly by another party will reciprocate by treating that party kindly in return.This theory of “reciprocity” underlies our third hypothesis, which predicts thatemployees who perceive their contract to be fairer will choose a higher level ofeffort than those who perceive their contract to be less fair As was the case for H2,this is a general hypothesis that does not distinguish between bonus contracts andpenalty contracts That is, higher perceived fairness is predicted to yield higheremployee effort in both bonus contracts and penalty contracts

H3: Employees who perceive their contracts to be fairer will expend highereffort

As explained above, the general effects of expected disappointment (H2) andperceived fairness (H3) on effort are predicted to operate in the same manner withinboth bonus contracts and penalty contracts However, as discussed below, the levels

of both expected disappointment and perceived fairness are likely to differ across

bonus and penalty contracts

With respect to disappointment, the theoretical construct of loss aversion dicts that expected disappointment would be greater under penalty contracts thanunder economically equivalent bonus contracts Loss aversion describes the well-documented finding that individuals are more averse to suffering a loss than they are

pre-to forgoing the same amount of gain (Kahneman and Tversky 1979) If employeesfacing penalty contracts frame the prospect of having to pay the penalty as a loss,they will expect to be very disappointed about having to pay the penalty In contrast,

if employees facing bonus contracts frame the prospect of not receiving an ically equivalent bonus as a forgone gain, they will expect to be less disappointedabout not receiving the bonus These asymmetric framing effects across contracttype lead to our fourth hypothesis

econom-H4: Employees facing a penalty contract will expect to be more disappointedabout having to pay a penalty than employees facing a bonus contract willexpect to be about not receiving an economically equivalent bonus

If greater disappointment results in more effort (H2), and disappointment isgreater under penalty contracts than under bonus contracts (H4), then it follows thatemployee effort should be greater under penalty contracts than under bonus con-tracts However, as explained below, the fact that reciprocity predicts an opposingeffect on effort prevents us from making such a simple directional prediction regard-ing the effect of contract frame (bonus or penalty) on employee effort

With respect to perceived fairness, virtually all of Luft’s (1994) participantsindicated in her post-experimental questionnaire that they thought that “mostemployees” would perceive a bonus contract to be fairer than an economicallyequivalent penalty contract Such perceptions could be due to a construct that Luftrefers to as “penalty aversion.” If employees are averse to penalty contracts becausethey view penalty contracts as punitive or negative, they are likely to perceivepenalty contracts as unfair In contrast, if bonus contracts are viewed more positivelybecause employees frame them as offering a potential reward, they are likely to beperceived as fairer than economically equivalent penalty contracts These expecteddifferences across contract types lead to our fifth hypothesis

H5: Employees perceive bonus contracts as fairer than economically equivalentpenalty contracts

Hypotheses H2-H5 are depicted in Figure 1, where it can be seen that if employeesconsider bonus contracts to be fairer than penalty contracts (H5) and also engage in

Penalty aversion:

Bonus contract

perceived as fairer

Employee Effort

Expected Disappointment

Perceived Fairness

Figure 1.

reciprocity (H3), then it follows that employee effort should be higher under bonuscontracts than under economically equivalent penalty contracts (bottom path inFigure 1) Of course, this prediction regarding employee effort is opposite to theprediction described earlier that effort will be higher under penalty contracts (toppath in Figure 1) as a result of the combined effect of loss aversion (H4) and expecteddisappointment (H2) Because these potential effects work in opposite directions, weare unable to predict the net effect on effort of framing contracts in bonus versuspenalty terms Therefore, we do not make a directional hypothesis regarding theeffect of contract frame on effort, but rather address this issue as our first researchquestion (RQ1 in Figure 1)

RQ1: Does employee effort differ under economically equivalent contractsframed in bonus versus penalty terms, and if so, which type of contractresults in higher effort?

We expand upon RQ1, by investigating a second research question, RQ2 (notdirectly identified in Figure 1), which involves isolating and measuring the poten-tially offsetting effects of loss aversion and perceived fairness on effort Specific-ally, RQ2 addresses whether expected disappointment, perceived fairness, or bothexpected disappointment and perceived fairness mediate the effect of contract frame(bonus versus penalty) on employee effort As explained earlier, if H4 and H2 (toppath in Figure 1) are supported, then contract frame is likely to affect effort by way

of expected disappointment However, if H5 and H3 (bottom path in Figure 1) arealso supported, then it is likely that contract frame also affects effort by way ofperceived fairness Because we cannot predict in advance whether expected dis-appointment, perceived fairness, or both will mediate the effect of contract frame

on effort, we address these issues in our second research question

RQ2: Does expected disappointment or perceived fairness mediate any effect

of contract frame on employee effort (examined in RQ1)?

3 EXPERIMENT

3.1 Overview

We conducted an experiment designed to address the hypotheses and research tions described above Participants were assigned to either a bonus contract or aneconomically equivalent penalty contract (described later) Their task was to choosetheir effort level In addition, they responded to questions designed to measure theirdegree of expected disappointment about not receiving the bonus or having to paythe penalty and their perceived fairness of the contract they faced when making theireffort choices After making their effort choices and responding to the expecteddisappointment and fairness questions, participants were shown the contract thatparticipants in the other experimental condition faced (i.e., bonus contract particip-ants were shown the penalty contract, and vice versa) and asked to indicate whichcontract they preferred

ques-3.2 Participants

Sixty-eight M.B.A students participated in the experiment Sixty-two percent ofthe participants had at least five years of professional business experience, with theremainder having between zero and five years of experience Forty-seven percent

of participants had worked under a bonus incentive contract No participants hadworked under a penalty incentive contract Both professional business experienceand incentive contract experience were distributed approximately equally across theexperimental (bonus and penalty) conditions

3.3 Design

Our experimental design included a manipulated between-subjects independent able, Contract Frame, with two levels (Bonus and Penalty) The design also includedtwo measured variables (Expected Disappointment and Perceived Fairness) that wereobtained from participants’ responses to questions in the experimental instrument.Finally, our design included two dependent variables: participants’ effort level choicesand their expressed contract preference As explained in the results section of thepaper, the specific combination of independent and dependent variables used for anyparticular analysis depended on the hypothesis or research question being addressed

vari-3.4 Procedures

The experiment was conducted in two back-to-back administrations, one for eachexperimental condition Each administration took approximately 30 minutes Parti-cipants were randomly assigned to either the Bonus or economically equivalentPenalty condition The bonus contract paid a salary of $20 plus a bonus of $10 ifthe target (high) outcome was achieved The economically equivalent penalty con-tract paid a salary of $30 with a $10 penalty if the target (high) outcome was notachieved These contracts are economically equivalent because under both contractsthe employees will receive $30 if the outcome is high and $20 if the outcome is low.Participants assigned to either condition were unaware that the alternative conditionexisted until after they made their effort choices and responded to the expecteddisappointment and perceived fairness questions

Participants in both conditions assumed the role of an employee of BuckleyCompany They received their base pay in cash ($20 in the bonus condition, $30 inthe penalty condition) at the start of the experiment, and were told that their finalpayment at the end of the experiment (i.e., the cash they retained or the additionalcash they received) would depend on the terms of their contract and the effort levelthey chose.2

The description of Buckley Company indicated that the company’s goalwas to maximize shareholder value Company management had instituted a newcompensation system designed to provide an incentive for employees to work hard

to achieve a high outcome so that the company could meet its aggressive ance goals The more effort an employee expended, the more likely it was that s/hewould achieve a high outcome

perform-Consistent with previous studies (e.g., Frederickson 1992; Fehr, Kirchsteiger andRiedl 1993; Fehr, Gächter and Kirchsteiger 1997; Hannan, Kagel and Moser 2002)disutility for effort was operationalized as a monetary cost to participants thatincreased with the level of effort chosen.3

Specifically, participants chose an effortlevel from 1 to 13, with the cost of effort increasing correspondingly in $.50 incre-ments from $.50 (1) to $6.50 (13) The probability of achieving a high outcome alsoincreased with the level of effort, rising in 5% increments from 30% (1) to 90% (13).The cost of effort and probabilities of achieving a high outcome were set such thatthe participants’ expected net payoff was identical ($22.50) across all 13 possibleeffort level choices.4

Participants were provided a table that showed the cost of effort and the ability of achieving (and not achieving) the high outcome for each of the 13 possibleeffort level choices (see Table 1) After reading a description of their employmentcontract and reviewing this table, each participant chose his or her effort level.Immediately after making their effort level choices, participants responded to thefairness and expected disappointment questions Participants rated the fairness of theemployment contract they faced in the experiment on a 13-point scale with endpointslabeled “not fair at all” (1), and “extremely fair” (13), and the midpoint labeled

prob-“moderately fair” (7) Participants rated how disappointed they would be if the come were low and therefore they did not receive the bonus (had to pay the penalty)

out-Table 1 Cost of Effort out-Tables for Penalty and Bonus Contract Frames

Penalty Contract Frame

Your Cost Cost Probability of Achieving a Probability of Achieving a Probability of not Achieving a effort of Effort of Effort High Outcome and High Outcome and High Outcome and Paying level Avoiding the $10 Penalty Avoiding the $10 Penalty the $10 Penalty

regarding participants’ professional work experience and their experience with ive contracts.

incent-After all participants had submitted their experimental materials, the actual come (high or low) was determined for each effort level (1 through 13) as follows:

out-A participant volunteer drew one chip from each of 13 bags (one for each effortlevel) Each bag contained red and blue chips in proportion to the outcome probabil-ity distribution corresponding to that effort level For example, because effort level 1had a 30% probability of a high outcome and 70% probability of a low outcome, thebag for effort level 1 contained 3 red chips (high outcome) and 7 blue chips (lowoutcome).5

After outcomes had been determined for each effort level, participants’final payments were calculated and they were paid in cash privately Bonus condi-tion participants who did not receive a bonus (outcome was low) were required to

Table 1 (cont’d)

Bonus Contract Frame

Your Cost Cost Probability of Achieving a Probability of Achieving a Probability of not Achieving a effort of Effort of Effort High Outcome and High Outcome and High Outcome and Not level Receiving the $10 Bonus Receiving the $10 Bonus Receiving the $10 Bonus

return a portion of their $20 base pay equal to the cost of their chosen effort level.Bonus condition participants who received a bonus (outcome was high) were paid anadditional sum equal to the $10 bonus minus the cost of their chosen effort level.Penalty condition participants who had to pay the penalty (outcome was low) wererequired to return a portion of their $30 base pay equal to the cost of their effort plusthe $10 penalty Penalty condition participants who did not have to pay the penalty(outcome was high) were required to return a portion of their $30 base pay equal tothe cost of their chosen effort level.

4 RESULTS

4.1 Tests of Hypotheses 1–5

H1 predicts that employees prefer bonus contracts to economically equivalentpenalty contracts To test this hypothesis we examined participants’ preference res-ponses after they considered both the original contract they faced in the experimentand the contract used in the other experimental condition (i.e., after bonus participantswere provided with the penalty contract, and vice versa) Overall, 65% of participantspreferred the bonus contract, 19% preferred the penalty contract, and 16% wereindifferent between the two Although conventional economic theory predicts thatall participants would be indifferent, 84% of participants expressed a preference, and

a significantly greater proportion (binomial test, p< 001) of these preferred the bonuscontract (65%) to the penalty contract (19%) Results were not significantly differentacross experimental conditions (chi square = 1.47, p = 48), with 60% (70%) pre-

ferring the bonus contract, 23% (15%) preferring the penalty contract, and 17% (15%)expressing indifference between the contracts in the bonus and penalty conditions,respectively Further, of those participants expressing a preference, the proportionpreferring the bonus contract in each experimental condition was significantly greaterthan the proportion preferring the penalty contract in that condition (binomial tests,

ps< 03) These results are consistent with H1, and as such, replicate Luft’s findingthat employees generally prefer bonus contracts to penalty contracts

H2 predicts that greater expected disappointment about having to pay the penalty

or not receiving the bonus will result in greater employee effort in both the bonusand penalty conditions To test this hypothesis, we first regressed participants’ effortchoices on their expected disappointment responses for the pooled data set Results

show a strong positive association (t = 5.61, p < 001), indicating that, consistent with

H2, effort increased significantly as expected disappointment increased Separate

regressions for the Bonus (t = 3.67, p < 002) and Penalty (t = 3.49, p < 002)

conditions yielded similar results

H3 predicts that higher employee fairness ratings of their contracts will result

in higher employee effort in both the bonus and penalty conditions To test thishypothesis we first regressed participants’ effort choices on their perceived fairness

ratings for the pooled data set Results showed a strong positive association (t =

2.79, p< 008), indicating that, consistent with H3, effort increased significantly as

perceived fairness increased Separate regressions for the Bonus (t = 3.13, p < 005) and Penalty (t = 2.08, p < 047) conditions yielded similar results.

H4 predicts that employees facing a penalty contract will expect to be moredisappointed about having to pay the penalty than employees facing a bonus contractwill be about not receiving the bonus In other words, participants’ expected dis-appointment will be asymmetric, reflecting loss aversion To test this hypothesis wecompared participants’ ratings of the degree of disappointment they expected tofeel if they did not receive the bonus in the Bonus condition to the degree ofdisappointment they expected to feel if they had to pay the penalty in the Penaltycondition The results, which are reported in Table 2, show that, consistent with H4,

participants’ degree of expected disappointment was significantly higher (t = 3.16,

p< 003) in the Penalty condition (mean = 9.36) than in the Bonus condition (mean

= 6.77) That is, despite the economic equivalence of the bonus and penalty tracts, participants indicated that they were significantly more averse to having topay the penalty than they were to not receiving the bonus These results reflect lossaversion because participants viewed paying the penalty as a bigger psychologicalloss than not receiving the bonus

con-H5 predicts that employees will perceive bonus contracts to be fairer thanpenalty contracts To test this hypothesis, we compared participants’ ratings of howfair they considered the contract they faced in the Bonus versus Penalty conditions

As shown in Table 2, Bonus condition participants rated the bonus contract (mean =

7.40) as significantly fairer (t = 2.41, p < 02) than Penalty condition participants

rated the penalty contract (mean = 5.30) These results are consistent with H5,

as well as with Luft’s post-experimental questionnaire results, which showed thatvirtually all of her participants thought that “most employees” would feel that abonus contract was fairer than an economically equivalent penalty contract

Table 2 Mean (standard deviation) of Expected Disappointment, Perceived Fairness and Effort Measures

(Bonus = Penalty) (two tailed)

4.2 Research Questions

Our first research question (RQ1) asks whether framing economically equivalentcontracts in bonus terms versus in penalty terms affects employee effort As shown

in Table 2, employee effort was significantly higher (t= 2.23, p = 029 two-tailed)

in the Penalty condition (mean = 9.58) than in the Bonus condition (mean = 7.40).This result can potentially be explained by the loss aversion documented earlier intests of H4, which indicated that Penalty condition participants expected to be moredisappointed about having to pay the penalty than Bonus condition participantsexpected to be about not receiving the bonus Combined with the finding that greaterdisappointment resulted in higher employee effort (H2), these results can explainwhy employee effort was greater in the penalty condition.6

The greater effort observed under the penalty contract runs contrary to a procity effect which predicts that effort will be greater under the bonus contract.Nevertheless, reciprocity could still be operating if the effect were dominated by themore powerful opposing effect of loss aversion Indeed, further analysis reportedbelow for our second research question is consistent with this interpretation.Our second research question (RQ2) asks whether Expected Disappointmentand/or Perceived Fairness mediate the effect of Contract Frame on Effort docu-mented in RQ1 To address this question, we conducted four regression analyses

reci-as follows:

(1) Effort =α + β1 Contract Frame+ε

(2) Effort = α + β1Contract Frame+β2Expected Disappointment +ε

(3) Effort = α + β1Contract Frame +β2Perceived Fairness +ε

(4) Effort =α + β1 Contract Frame +β2Expected Disappointment + β3PerceivedFairness+ε

where, Effort = participants’ effort choices

Contract Frame = 1 for Bonus condition, 0 for Penalty condition

Expected Disappointment = participants’ rating of the disappointment theyexpected to experience if they did not receive the bonus (Bonus condi-tion) or had to pay the penalty (Penalty condition)

Perceived Fairness = participants’ rating of the fairness of their contractThe results for these four regressions are reported in Table 3 We know from theanalysis reported for RQ1 that, overall, Effort was higher in the Penalty condition(Contract Frame = 0) than in the Bonus condition (Contract Frame = 1) This isconfirmed by the results of the first regression, which show that Contract Frame is

negatively related to Effort (t = −2.23, p = 029) The second regression examines

the extent to which the effect of Contract Frame on Effort is mediated by ExpectedDisappointment The results indicate that, consistent with the results of H2 reported

earlier, Expected Disappointment has a strong positive effect (t = 4.97, p < 001)

on Effort However, more importantly, including Expected Disappointment as an

explanatory variable in the second regression causes the effect of Contract Frame

on Effort to drop to nonsignificance (t = −.62, p = 536 in the second regression versus

t = −2.23, p = 029 in the first regression) These results indicate that Expected

Dis-appointment mediates the effect of Contract Frame on Effort That is, the reason thatemployees chose greater effort in the Penalty condition than in the Bonus conditionappears to be that, consistent with the loss aversion documented in H4, they weremore averse to having to pay the penalty in the Penalty condition than they were to

not getting the bonus in the Bonus Condition Moreover, the adjusted R2

increasedsubstantially when Expected Disappointment was included in the second regression

(R2

increased from 06 in the first regression to 31 in the second regression), ing that not only does Expected Disappointment mediate the effect of Contract on

show-Table 3 Effort Regressions

Intercept Contract Expected Perceived Adj R 2

Frame Disappointment Fairness

Number of observations = 68 for all models.

The full model (Model 4) is:

Effort = α + β1 Contract Frame + β2 Expected Disappointment + β3 Perceived Fairness + ε

where, Effort = participants’ effort choices

Contract Frame = 1 for Bonus condition, 0 for Penalty condition

Expected Disappointment = participants’ rating of the disappointment they expected to experience if they did not receive the bonus (Bonus condition) or had to pay the penalty (Penalty condition)

Perceived Fairness = participants’ rating of the fairness of their contract

Effort, but it also has a strong, separate influence on Effort within each of the Bonusand Penalty conditions These results are consistent with the top path in Figure 1.The third regression shows that Perceived Fairness also mediates the effect ofContract Frame on Effort (bottom path of Figure 1), but in the opposite direction ofExpected Disappointment Consistent with the reciprocity documented earlier in H3,

Perceived Fairness has a strong positive effect (t = 3.87, p < 001) on Effort,

indicat-ing that higher Perceived Fairness yields higher Effort In addition, after statisticallycontrolling for the effect of Perceived Fairness, the effect of Contract Frame on

Effort was actually stronger (t = −3.46, p < 002) than it was in the first regression (t = −2.23, p = 029) when Perceived Fairness was omitted from the regression.

That is, including Perceived Fairness in the regression does not weaken the effect

of Contract Frame on Effort as is the case in most mediation analysis, but ratherstrengthens it This is because, although both Expected Disappointment and Per-ceived Fairness mediate the effect of Contract Frame on Effort, they do so in oppo-site directions.7

A final important observation regarding the third regression is the

substantial increase in the adjusted R2

from 06 in the first regression to 22 in thethird regression, which indicates that in addition to mediating the effect of ContractFrame on Effort, Perceived Fairness had a separate effect on Effort within each ofthe Contract Frame conditions

Although Perceived Fairness was higher in the Bonus condition than in thePenalty condition (H5) and it affected Effort as predicted in H3 (i.e., higher per-ceived fairness led to greater effort), this effect (depicted in the bottom path ofFigure 1) was entirely dominated by the opposing effect depicted in the top path ofFigure 1 Taken together, the results of the first three regressions suggest that, whilereciprocity caused participants to choose more effort in the Bonus condition than inthe Penalty condition (third regression), this effect was dominated by the strongeropposing effect of loss aversion (second regression), which caused participants tochoose more effort under the penalty contract (first regression)

The fourth regression, which included both Perceived Fairness and Expected

Disappointment as explanatory variables, increased the adjusted R2

to 48, versus 22when only Perceived Fairness was included in the third regression, and 31 whenonly Expected Disappointment was included in the second regression As shown inTable 3, the effects of both Perceived Fairness and Expected Disappointment onEffort remain statistically significant in the expected directions in the fourth regression.These results confirm the interpretation offered above, which was based on the com-bined results of the first three regressions Specifically, while both Perceived Fair-ness and Expected Disappointment are important factors in explaining participants’effort levels, the effect of Perceived Fairness is dominated by the more powerfulopposing effect of Expected Disappointment.8

We also note that a marginally

signi-ficant effect of Contract Frame on Effort (t = −1.95, p = 056) remains after controlling

for both Perceived Fairness and Expected Disappointment in the fourth regression,

suggesting that, despite the high adjusted R2

(.48), there is still some other force notfully captured in our Expected Disappointment measure that caused participants tochoose more effort under the penalty contract than under the bonus contract.9

5 DISCUSSION

Our findings can be summarized as follows: Consistent with Luft (1994), we findthat employees generally prefer bonus contracts to economically equivalent penaltycontracts We extend Luft’s study by demonstrating that employee effort is higherunder a penalty contract than an economically equivalent bonus contract Our ana-lysis demonstrates that this finding is the result of two effects that work in oppositedirections, where the first effect dominates the second The first effect is due to lossaversion, which makes employees more averse to having to pay a penalty than to notreceiving a bonus, and causes them to choose more effort under the penalty contract.The second effect reflects reciprocity, which causes employees who consider theircontracts to be fairer to choose more effort Because employees generally perceivedthe bonus contract to be fairer than the penalty contract, reciprocity caused employ-ees to choose more effort under the bonus contract We find support for both of theseopposing effects, with reciprocity dampening, but not completely offsetting, thedominant effect of loss aversion on employee effort

Our results have important implications for understanding why in practice mostactual contracts are framed as bonus contracts Under conventional economic ana-lysis, it is irrelevant whether a contract is framed in bonus terms or penalty terms.However, Luft argued that because employees prefer bonus contracts, they woulddemand higher payments from firms to accept penalty contracts Thus, assuming noother differential cost between offering a bonus or penalty contract, firms maximizeprofits by offering bonus contracts However, our results show that firms do bear acost for offering bonus contracts rather than penalty contracts That is, employeeschoose more effort under penalty contracts, so offering a bonus contract gives upthe benefit of this increased effort Consequently, it is no longer clear that offering

a bonus contract maximizes firm profit

Of course, this brings us back to the original question of why in practice mostactual contracts are bonus contracts Conventional economic theory offers no expla-nation because it predicts indifference between bonus contracts and economicallyequivalent penalty contracts Given our results, Luft’s (1994) explanation that weobserve bonus contracts in the world because employees prefer them cannot be

a complete explanation because the attendant logic fails to recognize the cost offorgone effort associated with bonus contracts In our view, a better and morecomprehensive explanation is likely to be found only through additional researchdesigned to understand the full range of costs and benefits associated with each type

of contract

Along with Luft’s (1994) study, the results of this study clearly show that ventional economic analysis fails to capture either employees’ preferences for bonuscontracts or the fact that penalty contracts motivate higher effort Thus, we alreadyknow that there are important costs and benefits associated with incentive con-tracts beyond those typically assumed to exist in conventional economic analysis

con-We suspect there are still other costs associated with offering penalty contracts, orbenefits associated with offering bonus contracts, that are not yet reflected in any of

the currently available explanations for why penalty contracts are rarely observed inpractice For example, it may be that employees have ways to retaliate against a firmwho offers them a penalty contract other than to withhold effort In our experiment,withholding effort was the only possible means of retaliation against the firm How-ever, withholding effort also increased the chance of having to pay the penalty, andtherefore employees who were motivated by loss aversion to avoid the penalty had

no choice but to bear the higher cost of choosing higher effort

In contrast, in some actual work settings, employees could choose to work hard

to avoid the penalty just as they did in our experiment, but then quit their job or takeother retaliatory actions against the firm that would benefit the employee at theexpense of the firm If firms anticipate that such employee retaliation will be a likelyconsequence of using penalty contracts, a cost/benefit analysis may lead them toconclude that using bonus contracts is likely to maximize profits in the long run.Alternatively, in settings where employees have other options for extractingmonetary benefits (for example employee theft), employees may in fact withholdeffort (i.e., not exert more effort under a penalty contract than a bonus contract),but then extract monetary benefits through other means to make up for the forgoneincentive pay (Greenberg 1990) In this case, there would be an extra cost, but nooffsetting benefit, associated with using a penalty contract Consequently, firmswould likely maximize profits by offering bonus contracts Future research couldinvestigate whether such other potential costs of using penalty contracts can helpexplain why bonus contracts are typically observed in practice

ACKNOWLEDGMENT

We appreciate helpful comments from an anonymous reviewer, Jake Birnberg,Jim Boatsman, Larry Brown, Bryan Church, Harry Evans, Yuhchang Hwang, KathrynKadous, Steve Kaplan, Ed O’Donnell, Casey Rowe, Kristy Towry, Bill Waller andworkshop participants at the Second Asian Conference on Experimental BusinessResearch, the American Accounting Association annual meeting, Arizona StateUniversity, Emory University, and the University of Pittsburgh We also thank FredJacobs for providing experimental participants and Frank Luo for helping conductthe experiment This research was supported by grants from the Robinson College

of Business to Hannan and from the Katz Graduate School of Business to Hoffmanand Moser

NOTES

1 A recent study by Frederickson and Waller (2004) supports Luft’s (1994) findings in an experimental setting where firm participants and employee participants interact Specifically, employees demanded higher expected pay to accept an offer framed as a penalty contract versus an offer framed as a bonus contract, and firms accommodated this employee loss aversion by making higher offers in the penalty contract frame We note that Luft did not limit her explanation for why employees prefer bonus con- tracts to Kahneman and Tversky’s (1979) pure prospect-theory definition of loss aversion Nevertheless,

all the related effects she described are consistent with the more general notion of loss aversion which reflects the well-documented finding in psychology that the negative response to penalties, losses, punishment, etc is greater than the positive response to equivalent bonuses, gains, rewards, etc In addition, because all the loss-aversion related effects described by Luft (1994) and Frederickson and Waller (2004) cause employees to prefer bonus contacts to penalty contracts, they all lead to Luft’s conclusion that employers maximize profit by offering bonus contracts.

2 It was made clear to participants that they were required to pay back any penalty amounts before leaving the room An additional experimenter was posted at the door to ensure that no participant exited the room before settling their accounts with the experiment’s paymaster, and no participant attempted

to do so.

3 This operationalization of effort is consistent with the agency theory definition of effort (Baiman 1982)

in that (1) participants had control over the effort level choice, (2) higher effort increased the ability of reaching the target (high) outcome, and (3) participants derived disutility from choosing a higher effort level.

prob-4 For example, choosing effort level 1 yielded an expected payoff of 30 ($30) + 70 ($20) − $0.50 =

$22.50, while choosing effort level 10 yielded an expected payoff of 75 ($30) + 25 ($20) − $5 =

7 Perceived Fairness and Expected Disappointment are not significantly correlated with each other [Pearson (Spearman) correlation= −.105 (−.087), p > 40 (.47)].

8 We also used structural equation modeling to test the overall model depicted in Figure 1 Under this approach, a single covariance matrix is created and used to simultaneously estimate all links in the model (Kline 1998) Results from the overall model are almost identical to the corresponding individual tests reported for H2 – H5 and RQ1 and RQ2 Specifically, Expected Disappointment was higher under the Penalty contract and Perceived Fairness was higher under the Bonus contract Both Expected Dis- appointment and Perceived Fairness had a positive effect on Effort The path coefficients are equal to those reported in regression model 4 in Table 3 for Expected Disappointment to Effort (.62), Perceived Fairness to Effort (.48) and Contract Frame to Effort ( −1.57) The primary measure of fit for the structural equation model is a Chi-square statistic, which tests the null hypothesis that the proposed model is a good fit for the data For the model depicted in Figure 1, the Chi-square is not statistically significant ( χ 2= 000, p = 995), indicating that the model is a good fit To bolster confidence in our

interpretation of the causal path, an alternative model was specified which reversed the direction between Expected Disappointment and Effort That is, although we hypothesized that Expected Dis- appointment would result in higher Effort, a potential alternative explanation is that choosing higher effort caused participants to expect to be more disappointed if they had to pay the penalty or forgo the bonus The null hypothesis that the model is a good fit for the data is rejected for the alternative model ( χ 2= 11.06, p < 005), indicating that the alternative causal explanation is not tenable A similar model

which reversed the causal direction for Perceived Fairness also was not tenable ( χ 2= 23.14, p < 001).

9 We also ran a regression including all three independent variables included in the fourth regression and

all related interactions (R2 = 60) Results are consistent with those reported for the fourth regression in

that both Expected Disappointment and Perceived Fairness remain statistically significant ( ps< 001).

In addition, neither the 3-way interaction, nor the 2-way interactions between Contract Frame and Perceived Fairness or Contract Frame and Expected Disappointment are statistically significant The

significant interaction between Perceived Fairness and Expected Disappointment (t = −3.76, p < 01)

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